Equivalent units of production are a way of expressing partly finished work as if it were a smaller number of fully finished units. If a factory has 1,000 units that are each half complete at the end of a month, the work done on them equals 500 completed units. The idea is used in process costing, the method applied by businesses that make large volumes of identical products in continuous steps, such as paint, flour, chemicals, beverages or paper.
Equivalent units matter because a process-costing business cannot trace costs to individual items. Instead it collects all the costs of a department for a period and divides them by the output. Without equivalent units, the half-finished goods still on the production line would either get no cost at all or a full unit's cost, and both would distort cost of goods sold and the value of inventory on the balance sheet. The technique is a core part of cost accounting.
How equivalent units are calculated
The basic calculation for each cost category is:
Here is the actual count of units in a stage of production, and is how far along they are for that type of cost. The percentage is often different for each cost type. Direct materials are frequently added at the start of a process, so units in progress may be 100 percent complete for materials but only 40 percent complete for conversion costs, which are direct labor plus factory overhead added evenly as work proceeds.
Worked example
A bottling department starts the month with no work in process. During the month it starts 10,000 units, finishes and transfers out 8,000, and has 2,000 still in process at month end. The units in process have received all their materials but are only 25 percent complete for conversion. Costs for the month are $30,000 of materials and $42,500 of conversion costs.
- Materials equivalent units are 8,000 finished plus 2,000 times 100 percent, which equals 10,000.
- Conversion equivalent units are 8,000 finished plus 2,000 times 25 percent, which equals 8,500.
- Cost per equivalent unit for materials is $30,000 divided by 10,000, or $3.00.
- Cost per equivalent unit for conversion is $42,500 divided by 8,500, or $5.00.
Each finished unit therefore carries $8.00 of cost, so the 8,000 units transferred out are valued at $64,000. The ending work in process is valued at 2,000 times $3.00 for materials plus 500 times $5.00 for conversion, which is $8,500. Together the two figures account for the full $72,500 of cost, which is the check every cost-of-production report should pass.
Weighted-average and FIFO methods
When a department begins the period with units already partly complete, there are two ways to count equivalent units. The weighted-average method ignores how much work was done in the prior period and simply blends the beginning inventory's cost with the current period's cost. It is simpler and is common in practice. The FIFO method counts only the work done in the current period, so it separates the cost of finishing the opening units from the cost of units started and completed this month. FIFO gives managers a cleaner measure of current-period efficiency, which is useful when comparing actual costs with a budget. The choice is related to, but separate from, the inventory cost flow assumption used for finished goods.
Common difficulties
The weakest point in the calculation is the percentage-of-completion estimate, which is often a supervisor's judgment. A small change in the estimate shifts cost between finished goods and work in process, and therefore between the income statement and the balance sheet. Accountants also need to handle spoiled units: normal spoilage is usually absorbed into the cost of good units, while abnormal spoilage is written off as a loss for the period. Businesses that make custom products for individual customers generally use job order costing instead, and some combine process costing with absorption costing rules for external reporting.